IRS rule changes helped create a payment-focused hospital system

ByPatrick Masseo

March 5, 2019

Garfield Hospital in Washington in the early 20th century.Library of Congress

All three branches of the U.S. government — legislative, executive, and judicial — play important roles in shaping our health care system. Think of the passage of the Affordable Care Act, the Trump administration’s move to allow states to impose work requirements for Medicaid coverage, and Texas federal district court Judge Reed O’Connor’s ruling that the Affordable Care Act is unconstitutional. Often overlooked are small regulatory changes, such as adjustments to Internal Revenue Service codes over the past 70 years, that have allowed hospital care to evolve from a charitable mission into a profit-driven industry.

America’s original hospitals were almshouses. Funded by the public or charities, almshouses served primarily as places to quarantine the indigent who were stricken with maladies or dying. Individuals able to afford a physician’s fee bypassed these institutions, which Benjamin Rush, a physician and signer of the Declaration of Independence, once called “sinks of human life.” Separating the haves from the have-nots and protecting the better off from the burden of the less fortunate were not-so-thinly veiled purposes of these bygone institutions.

In the early 20th century, almshouses and hospitals, heavily dependent on private benefactors, were among eligible charitable organizations that received special tax considerations from the IRS and benefitted from tax rules about donations. With the passage of the modern tax code in 1954, a special designation — 501(c)(3) — was created that exempted charitable organizations from federal taxes. As a result, 501(c)(3) organizations often also received exceptions to various local and state taxes.

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The original 501(c)(3) regulations granted hospitals tax-exempt status not because they provided health care but because of their affiliation with a religious institution or if they claimed to serve an otherwise defined charitable purpose in the public’s interest. This reflected the expectation in American culture that hospitals were open to those in need.

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In 1956, as hospitals were evolving into centers for medical interventions, the Internal Revenue Service issued Revenue Ruling 56-185, which applied solely to hospitals. This ruling was the first to allow hospitals to qualify for federal tax exemptions if they fulfilled qualifications related to providing health care. That represented a deviation from the previous requirement of affiliation with a religious institution or fulfilling another charitable purpose.

Revenue Ruling 56-185 established four criteria that a hospital must fulfill to qualify for 501(c)(3) tax-exempt status:

be organized as a nonprofit charitable organization for the purpose of operating a hospital for the care of the sick

be operated to the extent of its financial ability for those not able to pay for the services rendered and not exclusively for those who are able and expected to pay

not restrict the use of its facilities to a particular group of physicians and surgeons, such as a medical partnership or association

net earnings must not benefit directly or indirectly any private stakeholder or individual

Through criteria 2 of Revenue Ruling 56-185, the IRS — not the legislative, executive, or judicial branches of government — mandated that tax-exempt hospitals must provide care to patients who were unable to pay without an expectation of payment.

Nearly a decade later, President Lyndon Johnson signed into law the Social Security Amendments of 1965, which included the founding of Medicare and Medicaid. At the time, Medicare and Medicaid were thought to provide a step toward universal coverage. Many Americans, however, remained uninsured, the modern equivalent of citizens for whom almshouses and hospitals were originally created.

In 1969, the IRS issued Revenue Ruling 69-545, which updated the federal tax exemption requirements for hospitals. This ambiguous ruling, written as a case example rather than a defined list, included a subtle change of language that permitted tax-exempt hospitals to restrict access to care depending on a person’s ability to pay. For many individuals, that meant their health insurance status. According to Revenue Ruling 69-545, a hospital that operates as described as follows (emphasis added) would qualify:

The hospital operates a full time emergency room and no one requiring emergency care is denied treatment. The hospital otherwise ordinarilylimits admissions to those who can pay the cost of their hospitalization, either themselves, or through private health insurance, or with the aid of public programs such as Medicare. Patients who cannot meet the financial requirements for admission are ordinarily referred to another hospital in the community that does serve indigent patients.

This language is a subtle yet monumental contradiction of the IRS’s original 1956 guidance, which stated that a 501(c)(3) hospital “must not, however, refuse to accept patients in need of hospital care who cannot pay for services.”

Revenue Ruling 69-545 was neither an act of Congress nor a flashy executive order, yet it laid the foundation for the U.S. health care system to become driven by payment, a privilege of the rich and a necessity continually out of reach for the poor.

The year after this ruling appeared, The Tax Lawyer, a publication of the American Bar Association, described the 1969 rule change as “representing a shift by the [Internal Revenue] Service from requiring the admission of a substantial number of charitable cases in order to qualify for exempt status.”

A 1971 paper written by Marilyn G. Rose for the Catholic University Law Review correctly forecast the implications of this new ruling. “Most importantly, this tax policy [Revenue Ruling 69-545] operates as unwise health policy by perpetuating and enlarging the gulf between the health care available to the rich and that available to the poor,” Rose wrote.

Beyond those publications, I found little evidence of journalistic coverage of the 1969 rule change. Only a handful of academic papers on it were published between the 1970s and the 1990s. New attention was given to the tax-exempt qualifications of hospitals and their history in the 2000s, driven partly by discussions of health care reform.

In 1983, IRS Revenue Ruling 83-157 stepped further away from the original 1956 guidance that required hospitals to provide care regardless of a patient’s ability to pay. This ruling let state health planning agencies determine whether operating an emergency department is “unnecessary and duplicative” in a community. This caveat made it possible for specialty hospitals, such as eye or cancer hospitals, to deny service to patients unable to afford their care without fear of losing tax-exempt status because these institutions, with state approval, operated without providing emergency care, which the IRS’s 1969 ruling had required.

In 2010, the Affordable Care Act updated the requirements for hospitals to earn tax-exempt status. Under the act, a hospital’s tax-exempt status is partially dependent on its informing patients of the availability of the hospital’s financial assistance policy, limits on the amount it can charge for uninsured patients, and not pursuing vaguely defined abusive collection practices. This change in the Affordable Care Act (due in large part to the work of Republican Sen. Chuck Grassley of Iowa) carries on the legacy of the 1969 ruling, remaining grounded in the idea that health care is a commodity, not a right.

As federal and state legislatures take up health care bills, and presidential hopefuls propose health care reforms, they need to acknowledge how it is shaped by tax codes, administrative regulations, and other nonlegislative actions. Instead of discussing universal coverage, we should be pushing hospitals back to their American roots: open to all, in service of those most in need, and separating care from payment.

It’s time to implement and enforce policies that hold tax-exempt hospitals accountable for serving the public, promoting health, and earning their tax-exempt status. A first step would be for Congress to push for stronger enforcement of policies written into section 501(r)(3) of the tax code following passage of the Affordable Care Act.

Building on these policies, to qualify for tax-exempt status, hospitals should be required to spend at least 5 percent of their revenues on community-building activities as measured by Schedule H Part II of IRS Form 990. This 5 percent would match the traditionally expected amount of charity care hospitals provided before the IRS first introduced its rule changes a half-century ago. In addition, the Department of Health and Human Services should be given regulatory authority to evaluate if tax-exempt hospitals are complying with the community needs assessment and implementation requirements of section 501(r)(3).

Hospitals investing in the communities they serve will result in better long-term health outcomes instead of continued short-term interventional care. It would also return hospitals to their historic purpose of serving Americans who are most in need, driven by mission not payment.

Patrick Masseo is a program director and analyst at a nonprofit safety net hospital in the South Bronx, N.Y.

The story clearly shows that health care in America (among other things) has ALWAYS discriminated against the poor and non-rich. It;s time to stop screwing around with band aid solutions. Amend the Constitution to make health a basic human right and create universal health care. Make all health care providers, health insurance companies accepting Universal Health Care federal monies non-profit. Allow Universal Health Care to negotiate drug prices and cap drug company profits at 21%. Stop the BS – we are all tired of it and the politics and bribery. PS, Vote for me for president!